DIVERSIFIED TAX TIDBITS by Mark A. Burns
When someone starts a new business, the business entity they most commonly choose is a Limited Liability Company (LLC). This often make sense, since the LLC provides legal protection and is very easy and cost effective to establish and maintain. Also, for tax purposes, when it is a Single Member LLC (SMLLC), the income and expenses for the SMLLC normally get reported on the owner’s personal tax return on Schedule C, rather than on a separate income tax return for the business.
The net profit from a business is subject to two different levels of tax – regular income tax at the owner’s regular tax bracket, as well as Self Employment (SE) taxes.
When someone is a W-2 employee, FICA taxes (Social Security and Medicare) are withheld from their pay, and the employer matches those taxes dollar for dollar. But with a SMLLC, the owner is both employee and employer and so they must pay SE taxes (equivalent of FICA taxes) on the entire net profit of the business.
The SE taxes will generally be about 14 percent of net profit. As the business becomes more profitable, this can become a sizable tax hit. When that happens, there may be a different way to go to reduce taxes, i.e., electing to be taxed as an S Corporation.
As an S Corporation, the business owner is required to take a W-2 salary but only that portion of the profits is subject to SE/FICA taxes. The rest of the profits are not subject to SE/FICA taxes. So the more profitable a business is, the more potential for tax savings through avoidance of SE taxes on the non-salary portion of the income.
Based on the previous paragraph, one might be tempted to inquire, “Why take out any W-2 salary?” Well the answer is that the IRS requires “reasonable” W-2 compensation be paid to the business owner. What is “reasonable”? That is not specifically defined by the IRS and depends on all the facts and circumstances.
We have successfully worked with many of our business clients to elect S Corporation tax status to help them save taxes. The average savings is about $5,000 per year, and in at least one case, the savings was as high as $50,000 per year.
Also, it should be emphasized that if an LLC elects to be taxed as an S Corporation, it maintains its legal status as an LLC. Only the way it is taxed changes. The election to do this is made by filing a form with the IRS, and approval is normally automatic.
The above is a very general overview of what can be a very complicated subject. Each person’s particular situation can be unique. Always consult a tax professional if you are uncertain about how tax matters might affect you.
Mark A. Burns, M.B.A., is a C.P.A. with Diversified Financial Solutions PC in Southbury. He can be reached at 203-264-3131 or Mark@DFSPC.biz.
